Defense industry braces for major spending cuts

FORTUNE — Budget watchdogs of all political stripes and military contractors are sparring furiously over the effects of truncated government spending, a matter where emotions soar over such hot-button issues as unemployment and national security.

While even the most ardent military spenders concede that national defense must come at a lower price tag, just how modest that price needs to be is the debated question. As the campaigns in Iraq and Afghanistan wind down, Pentagon contracting giants have been preparing for billions of dollars in defense spending cuts.

And now they are facing an additional sum — just under $500 billion — in automatic cuts triggered by a federal budget deal struck in 2011. Defense spending did not tumble over the cliff at the New Year, but lockstep cutbacks could start kicking in about two months from now.

The proposed cuts have drawn strident criticism from federal lawmakers – defending businesses in their districts or states – contractors, and military leaders. An automatic reduction “cuts blindly and it cuts bluntly. It compounds risk and it compromises readiness,” warned Gen. Martin E. Dempsey, chairman of the Joints Chiefs of Staff, in a public statement he made earlier this month.

The top contracting companies have generally been more circumspect, allowing the major defense industry group the Aerospace Industries Association to castigate lawmakers and the White House. Last week, the group’s chief executive, Marion Blakey, warned in a statement that “more than 2 million Americans across all sectors of the economy will lose their jobs starting in 57 days if our political leaders fail to fix the self-inflicted wound of sequestration and the dangers it poses to our warfighters and national security.”

Congress and the Obama Administration will need to strike a new deal in late March to avoid chopping billions, across the board, from defense budgets. As of now, nearly 9% will be lopped off spending for all activities for the remaining months of the current fiscal year, which began last October.

Such a squeezed schedule of cuts on Pentagon operations could translate into furloughs as long as four weeks for some of its nearly 800,000 civilian employees. Anticipating that Congress and the White House may not reach a budget deal, the Pentagon earlier this month froze civilian hiring, curbed maintenance spending, limited some travel and conferences, and delayed approval of some contracts.

But prime contractors Lockheed Martin (lmt), Boeing (BA), Raytheon (rtn), Northrop Grumman (NOC), and General Dynamics (GD) are likely to feel a less painful hit to their pocketbooks, at least in the short-term, than advertised. These firms will announce their 2012 results at the end of the month, but analysts say that, despite slowing sales, most of the defense behemoths already have taken aggressive cost-cutting steps to keep their profit margins healthy.

“Sales of all major contractors are in the low single-digits,” said William Loomis, a defense industry analyst at investment firm Stifel Nicklaus, “and those for Lockheed are flat. But these companies know the country is in a fiscal bind and they are prepared for the next down cycle.”

The company’s analysis of a group of large contractors showed that defense firms took an average 2.1% hit in sales last year. Loomis estimates that the major contractors he follows, which include General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon, will see sales decline by an average of 0.4% this year.

Some weapons programs, of course, will receive larger reductions than others, but large contractors seem prepared to weather the worst of any budget slashing. Lockheed reported fairly stable third-quarter results last October, and did not indicate that any major programs were in jeopardy.

“Even a 9% cut won’t be a precipitous drop for major programs,” says Todd Harrison, a defense analyst for the Center for Strategic Budget Analysis, a bipartisan nonprofit organization. “The change will be gradual, taking place over four to five years involving extensions or additions to contracts. The government is obliged to pay current contracts.”

Big contractors are still winning high-dollar contracts. Boeing, in November, won a $4 billion contract to upgrade fighter jets for Saudi Arabia. That was the biggest deal among the $21 billion in U.S. military contracts awarded that month. The Department of Defense announces contract awards daily, but the high-ticket contracts are not flagged.

In addition to cutting back their ranks, top defense firms also are diversifying into other growing fields including, for example, health care and information technology. Some have acquired smaller companies with expertise in those specific areas to provide some cushion against defense spending downturn. The big firms now are winning contracts with federal government health agencies, particularly in areas like electronic medical records and other information technology.

“Defense spending is cyclical,” notes Harrison, “It ramps up, and declines but 9/11 was a turning point so from 2001 through 2010, it was on the rise but, given time, it would inevitably fall.”

A broad swath of cuts will sweep in federal defense department personnel who oversee auditing and compliance, he warns. And that could undercut any gains from slashing defense spending.

“Aside from the morale issue, such spending reduces workload capacity, which is needed because some contracts will need to be renegotiated, and there is always the need for oversight,” he adds.

The plus side, Harrison notes, is that federal defense officials “will have to get more innovative. They need to go out and draw in companies with new products and innovative ways.”

During World War II, Harrison notes, Kaiser Permanente had thousands of people working at its shipyards in California, and it was one of the nation’s largest shipbuilders. When the war ended, Kaiser Permanente was able to build on the expertise it had developed in caring for its workers and become a major force in the country’s healthcare industry.

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